Dedicated to dismantling the Ivory Tower and attempting, in some small way, to help revive the social science of economics.

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Saturday, December 12, 2009

The Classroom of Mainstream Economics

Scene: first day of first econ class

"Welcome to economics 101. By the end of this semester I hope to indoctrinate you into the cult of economics, just like my teachers indoctrinated me. But first, we must define economics.

In order to do that, you need to know some of the jargon of the trade. Does everyone know what it is to be selfish? Economics starts out recognizing that people always act for their own gains - and there is nothing wrong with that ever. Oh wait, I see a hand... what's that?... you say what about seemingly unselfish behavior and what about acts toward a common good? No No No, see I just told you economics shows us that people don't really care or need to worry about these things. See look, I'll prove it (writes a utility function on the board). See? This math equation says so. Ahem, ok, moving on....

Second, economics recognizes that there are scarce resources, and that the best way to allocate these resources is to let selfish people trade them in a market. These markets always function perfectly and in doing so, create the most efficient system possible.

That brings us to our second term: 'efficiency'. You see class, 'efficiency' is a necessary result of the indoctrination I'm teaching you today. Because selfish people are allowed to own property, and because they are allowed to freely trade in a market, society's gains are maximized. Imagine one of these markets was baking pies. Efficiency is basically giving society as much of that pie as possible.

Yes? You have another question... what's that you say? What about if you are a person that wants a piece of pie and can't afford it? No No No. You aren't understanding right. Economics doesn't have anything to say about equity or fairness or things that Europeans care about, economics talks about important things, like making sure we don't just have a blueberry pie, we have blueberry pie with lots of whipped cream. That's what's important here. See, because the more pie we have, we could, if we wanted to, allocate some of the leftover scraps to this poor person. But I kinda like whipped cream alot, so...., luckily for her economics tells us not to worry!

...Anyway, these irrational questions are making me get off topic. I need to get back to the indoctrination. But incidentally, that reminds me of one more term we need to understand: 'rationality'. Economics assumes that everyone is rational and that everyone has well-defined preferences and acts in their own best interest. ...You have another question? What if people's preferences change frequently over time or are different in different situations? I can see you really are going to need a hand in this class.... Your question is a non starter! You see, rationality and having a complete set of information --- these are just simplifying assumptions so that these awesome math equations (stare longingly) I just drew on the board can reveal to us their secrets! See, look!

If we didn't make these assumptions, I wouldn't be able to teach economics. If I wasn't able to teach economics, I wouldn't be able to indoctrinate you. Were I not able to indoctrinate you, then you won't be able to be an intelligent person - and if you aren't able to be an intelligent person, then you won't be able to indoctrinate the next generation! Do you understand now Garth?"

Funny to read someone who is very much in the system spouting off like this. Sounds like "all economists are Ivory Tower idiots except for me".

The problem has never been the economists but the people who believe in the economists. It seems completely obvious to me that the economic system is way too complex for anyone to ever understand how it actually works, but this doesn't stop people (read policymakers) believing in economists who claim they do understand it and can even control the beast...

It doesn't matter what you actually know. It only matters what you can convince someone to believe you know.

The truly knowledgeable downplay their knowledge for they understand their own shortcomings. The "just enough knowledge to be dangerous" are the ones who paint the world black and white and sell their voodoo to children and politicians.

1. Is it really hard to read the black on the blue? It looks fine to me....

2. I am 'in the system' in that I teach macro. I try to teach with a broad brush and open topics that are mainstream and not so mainstream. I certainly don't think I know more than anybody else, but I am opinionated about my concerns for the way the field has been going over the last number of decades. Maybe sometimes I go overboard, I'd rather over-express my opinions than not express them at all.

Regarding the proof: the equation should be [G–T] = [S–I] + [Im–X].This just means that a budget deficit must be funded by foreigners when the condition of S=I holds. ...And unless private investment is funded by foreigners, crowding out may occur from a budget deficit. Of course, the key to Keynesianism is that if S>I, the "glut of savings" can be siphoned to a budget deficit with little-to-no problem of crowding out of private investment.

mine went out of their way to acknowledge that people care about all sorts of things other than their own consumption, and the efficiency as defined here is a long way from what we might call social welfare (I think some mainstream textbooks make these points too).

My teachers then went on to say we can learn some insights from simple models with simple utility functions etc.

Oh yes, my post is an 'extreme'. But by "going out of their way"...exactly how far out of the way did they go? Did they do as much in depth analysis on challenging key assumptions as they did going into the results of those assumptions? Most teachers I had mentioned the complexities and the social welfare issues - and many textbooks devote a couple pages to it, but then it proceeds on with the assumptions anyway as if the other important items were just a requirement by their publisher. Teachers did the same.

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Garth you got the causality backwards, and this is important. The Government Deficit isn't financed with the private sector surplus or current account deficit, it's the other way around. Look what happens when the government deficit spends i.e. net credits bank accounts. (G>T)

3) Government pays interest on treasuries, this is like any gov spending, can be done with taxes or by issuing more debt.

So really what happens when government deficit spends is it creates private sector savings, as proven by the accounting identity. In this case a treasury. Since the fed is the monopoly supplier of reserves, there is no way for the private sector to net save unless the gov deficit spends. Hope this clears it up. Let me know if there are questions.

Thanks for the post man. I agree the equations are the same. My issue was I didn't understand his/hers post and therefore defaulted in my response to the way it is typically written out and added the basic keynesian argument for fiscal stimulus. It never even occured to me to think about post keyensian credit theory.

Regarding your post, which seems to be the point anon was trying to make..... I have no real beef. I have studying up over the last 3 or more years on post Keynesian economics precisely because of insights such as these. Like the basic idea that loans often create deposits, not the other way.

As with everything though, I find neither side is truly open minded. Chicago schoolers fails to see reality for what it is- that speculation and risk taking financers often can drive the demand for loans. But post Keynesian too fail to nevertheless note that, as Minsky would say himself, these lending forms inherently create bubbles and bursts but are not long-run sustainable. The only long-run sustainable action is via more regulation to more closely tie loans to deposits and collateral, or a complete overhaul of our financial system.

More to the point, I'm still not entirely convinced that a savings glut can only be sourced by government deficits in a closed economy. I think it may be more realistic to say the causality runs both ways. But I'm open to discussing this further.

Regardless, post Keynesian credit theory explains reality much better, it explains we are going to keep having these problems get worse but it has not yet come up with a real solution everyone can agree on.

...I should also like to point out that the classical idea that money is multiplied (via loans) from deposits and total deposits are limited by the Fed since they control base money, is accurate. So the classicals represent the limits of the demand for deposits. The problem the classicals get into is they don't see the connection that the full demand for the loans is not due to the deposits, so if banks, firms or individuals are over-leveraged (ie. maximum amount of money is created), and the demand for loans are not based on sound assets, then the economy is going to be in real trouble. Additionally, they fail to realize that if the Fed is continually accommodating this unsound demand, the economy is even more serious trouble. I believe I have a paper linked on my blog about this very loop.

Chicago school doesn't recognize reality... Agreed."But post Keynesian too fail to nevertheless note that, as Minsky would say himself, these lending forms inherently create bubbles and bursts but are not long-run sustainable. The only long-run sustainable action is via more regulation to more closely tie loans to deposits and collateral, or a complete overhaul of our financial system."

What good does tying loans with deposits do? The central bank can, and should, provide whatever liquidity is necessary. They didn't in the case of Northern Rock, so you got the old fashioned run on the bank. The regulations should on capital requirements. The US essentially gave up their capital requirements, so we have banks that are liquid but insolvent. With time I guess they may recapitalize themselves, will be interesting to see how that turns out.

More to the point, I'm still not entirely convinced that a savings glut can only be sourced by government deficits in a closed economy.

Arguing with an accounting identity is like saying the world is flat. If one side has a surplus, another side must have a deficit. Just like all countries can't have a trade surplus, at least one country must have a trade deficit. I think it may be more realistic to say the causality runs both ways. But I'm open to discussing this further. :-) Very cool of you.Regardless, post Keynesian credit theory explains reality much better, it explains we are going to keep having these problems get worse but it has not yet come up with a real solution everyone can agree on.

Some day the sun will go dark, and it won't matter how well the economy is functioning when it happens. We need to get off our planet and colonize another if we are to survive. I see the economic system as a matter of coming up with a system that serves the mental life of the people in the most optimal way. This may not be the goals of everyone in the economy, but I think the majority are behind me. As a people we need to personally value the future... How to achieve it can and should be debated and solved, I have no tolerance for petty bickering and voluntary ignorance that consumes the economics profession.

...I should also like to point out that the classical idea that money is multiplied (via loans) from deposits and total deposits are limited by the Fed since they control base money, is accurate.

The money multiplier is a myth. Banks make loans, which create deposits (bank liabilities) the fed must accommodate the need for reserves or they won't hit their overnight target as I've explained on FB. Now the Austrian school wants 100% reserve requrements. When Michael Balognie suggested something like 50% it caught me off guard since I never considered it. Now as I have explained, the reserve requirements do not give central banks control over the money supply, they give central banks control over the price of money, the interest rate, that is how they influence credit creation. The more reasonable of the Austrian school think that you should forgo your right to withdrawal your deposit for a period of time as a way to extend credit. This is a big topic, that leads to the question of who should be in control over what gets funded, it was a mistake for me to go on this tangent...

So the classicals represent the limits of the demand for deposits. The problem the classicals get into is they don't see the connection that the full demand for the loans is not due to the deposits, so if banks, firms or individuals are over-leveraged (ie. maximum amount of money is created), and the demand for loans are not based on sound assets, then the economy is going to be in real trouble. Additionally, they fail to realize that if the Fed is continually accommodating this unsound demand, the economy is even more serious trouble. I believe I have a paper linked on my blog about this very loop.

Woah! That's a mouthful. If I understand your main point (you had a lot of points), you worry that too much credit is being created, thanks to central bank accommodation, then what can be expected to be paid back. Furthermore GDP increases by credit creation is creating unsustainable demand bubbles that can blow up the economy. Did I get this right?

First of all there is inherent risk involved with any loan, any business plan, no matter how well thought out. As for the ability to repay it, it depends on if you're talking about net deleveraging for a sector of the economy (which can only come from another sector's leveraging as an offset) or just overall leveraging. For net measures, you have to look at the financial sector balances. For overall leverage, you can look at flow of funds measures of total debt for different sectors (households, non-financial biz, etc.). Basic measures of growth in bank loans is another possible measure. I personally also like to look at debt service for the household sector, since debt service is actually a bit more important than debt . . . I can have more debt if the cost of servicing it doesn't rise, for instance.

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Garth Brazelton

About Me

I work for the Indiana Economic Development Corporation as the Director of Operations and Business Systems, and I teach macroeconomics at Indiana University (Indianapolis). Previously, I was an Economist at the US DOT in Cambridge, MA. This blog does not represent the opinions of any of these organizations.